Is My Money Safe? Reading Banks' Balance Sheets
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Is My Money Safe? Reading Banks' Balance Sheets
By Sam Vaknin
Author of "Malignant Self Love - Narcissism Revisited"
Banks are institutions where miracles happen regularly. We rarely
entrust our money to anyone but ourselves - and our banks. Despite a
very chequered history of mismanagement, corruption, false promises
and representations, delusions and behavioural inconsistency - banks
still succeed to motivate us to give them our money. Partly it is
the feeling that there is safety in numbers. The fashionable term
today is "moral hazard". The implicit guarantees of the state and of
other financial institutions move us to take risks which we would,
otherwise, have avoided. Partly it is the sophistication of the
banks in marketing and promoting themselves and their products.
Glossy brochures, professional computer and video presentations and
vast, shrine-like, real estate complexes all serve to enhance the
image of the banks as the temples of the new religion of money.
But what is behind all this? How can we judge the soundness of our
banks? In other words, how can we tell if our money is safely tucked
away in a safe haven?
The reflex is to go to the bank's balance sheets. Banks and balance
sheets have been both invented in their modern form in the 15th
century. A balance sheet, coupled with other financial statements is
supposed to provide us with a true and full picture of the health of
the bank, its past and its long-term prospects. The surprising thing
is that - despite common opinion - it does.
But it is rather useless unless you know how to read it.
Financial statements (Income - or Profit and Loss - Statement, Cash
Flow Statement and Balance Sheet) come in many forms. Sometimes they
conform to Western accounting standards (the Generally Accepted
Accounting Principles, GAAP, or the less rigorous and more fuzzily
worded International Accounting Standards, IAS). Otherwise, they
conform to local accounting standards, which often leave a lot to be
desired. Still, you should look for banks, which make their updated
financial reports available to you. The best choice would be a bank
that is audited by one of the Big Four Western accounting firms and
makes its audit reports publicly available. Such audited financial
statements should consolidate the financial results of the bank with
the financial results of its subsidiaries or associated companies. A
lot often hides in those corners of corporate holdings.
Banks are rated by independent agencies. The most famous and most
reliable of the lot is Fitch Ratings. Another one is Moody's. These
agencies assign letter and number combinations to the banks that
reflect their stability. Most agencies differentiate the short term
from the long term prospects of the banking institution rated. Some
of them even study (and rate) issues, such as the legality of the
operations of the bank (legal rating). Ostensibly, all a concerned
person has to do, therefore, is to step up to the bank manager,
muster courage and ask for the bank's rating. Unfortunately, life is
more complicated than rating agencies would have us believe.
They base themselves mostly on the financial results of the bank
rated as a reliable gauge of its financial strength or financial
profile. Nothing is further from the truth.
Admittedly, the financial results do contain a few important facts.
But one has to look beyond the naked figures to get the real - often
much less encouraging - picture.
Consider the thorny issue of exchange rates. Financial statements
are calculated (sometimes stated in USD in addition to the local
currency) using the exchange rate prevailing on the 31st of December
of the fiscal year (to which the statements refer). In a country
with a volatile domestic currency this would tend to completely
distort the true picture. This is especially true if a big chunk of
the activity preceded this arbitrary date. The same applies to
financial statements, which were not inflation-adjusted in high
inflation countries. The statements will look inflated and even
reflect profits where heavy losses were incurred. "Average amounts"
accounting (which makes use of average exchange rates throughout the
year) is even more misleading. The only way to truly reflect reality
is if the bank were to keep two sets of accounts: one in the local
currency and one in USD (or in some other currency of reference).
Otherwise, fictitious growth in the asset base (due to inflation or
currency fluctuations) could result.
Another example: in many countries, changes in regulations can
greatly effect the financial statements of a bank. In 1996, in
Russia, for example, the Bank of Russia changed the algorithm for
calculating an important banking ratio (the capital to risk weighted
Unless a Russian bank restated its previous financial statements
accordingly, a sharp change in profitability appeared from nowhere.
The net assets themselves are always misstated: the figure refers to
the situation on 31/12. A 48-hour loan given to a collaborating
client can inflate the asset base on the crucial date. This
misrepresentation is only mildly ameliorated by the introduction of
an "average assets" calculus. Moreover, some of the assets can be
interest earning and performing - others, non-performing. The
maturity distribution of the assets is also of prime importance. If
most of the bank's assets can be withdrawn by its clients on a very
short notice (on demand) - it can swiftly find itself in trouble
with a run on its assets leading to insolvency.
Another oft-used figure is the net income of the bank. It is
important to distinguish interest income from non-interest income.
In an open, sophisticated credit market, the income from interest
differentials should be minimal and reflect the risk plus a
reasonable component of income to the bank. But in many countries
(Japan, Russia) the government subsidizes banks by lending to them
money cheaply (through the Central Bank or through bonds). The banks
then proceed to lend the cheap funds at exorbitant rates to their
customers, thus reaping enormous interest income. In many countries
the income from government securities is tax free, which represents
another form of subsidy. A high income from interest is a sign of
weakness, not of health, here today, gone tomorrow. The preferred
indicator should be income from operations (fees, commissions and
There are a few key ratios to observe. A relevant question is
whether the bank is accredited with international banking agencies.
These issue regulatory capital requirements and other mandatory
ratios. Compliance with these demands is a minimum in the absence of
which, the bank should be regarded as positively dangerous.
The return on the bank's equity (ROE) is the net income divided by
its average equity. The return on the bank's assets (ROA) is its net
income divided by its average assets. The (tier 1 or total) capital
divided by the bank's risk weighted assets - a measure of the bank's
capital adequacy. Most banks follow the provisions of the Basel
Accord as set by the Basel Committee of Bank Supervision (also known
as the G10). This could be misleading because the Accord is ill
equipped to deal with risks associated with emerging markets, where
default rates of 33% and more are the norm. Finally, there is the
common stock to total assets ratio. But ratios are not cure-alls.
Inasmuch as the quantities that comprise them can be toyed with -
they can be subject to manipulation and distortion. It is true that
it is better to have high ratios than low ones. High ratios are
indicative of a bank's underlying strength, reserves, and provisions
and, therefore, of its ability to expand its business. A strong bank
can also participate in various programs, offerings and auctions of
the Central Bank or of the Ministry of Finance. The larger the share
of the bank's earnings that is retained in the bank and not
distributed as profits to its shareholders - the better these ratios
and the bank's resilience to credit risks.
Still, these ratios should be taken with more than a grain of salt.
Not even the bank's profit margin (the ratio of net income to total
income) or its asset utilization coefficient (the ratio of income to
average assets) should be relied upon. They could be the result of
hidden subsidies by the government and management misjudgement or
understatement of credit risks.
To elaborate on the last two points:
A bank can borrow cheap money from the Central Bank (or pay low
interest to its depositors and savers) and invest it in secure
government bonds, earning a much higher interest income from the
bonds' coupon payments. The end result: a rise in the bank's income
and profitability due to a non-productive, non-lasting arbitrage
operation. Otherwise, the bank's management can understate the
amounts of bad loans carried on the bank's books, thus decreasing
the necessary set-asides and increasing profitability. The financial
statements of banks largely reflect the management's appraisal of
the business. This has proven to be a poor guide.
In the main financial results page of a bank's books, special
attention should be paid to provisions for the devaluation of
securities and to the unrealized difference in the currency
position. This is especially true if the bank is holding a major
part of the assets (in the form of financial investments or of
loans) and the equity is invested in securities or in foreign
exchange denominated instruments.
Separately, a bank can be trading for its own position (the Nostro),
either as a market maker or as a trader. The profit (or loss) on
securities trading has to be discounted because it is conjectural
and incidental to the bank's main activities: deposit taking and
Most banks deposit some of their assets with other banks. This is
normally considered to be a way of spreading the risk. But in highly
volatile economies with sickly, underdeveloped financial sectors,
all the institutions in the sector are likely to move in tandem (a
highly correlated market). Cross deposits among banks only serve to
increase the risk of the depositing bank (as the recent affair with
Toko Bank in Russia and the banking crisis in South Korea have
Further closer to the bottom line are the bank's operating expenses:
salaries, depreciation, fixed or capital assets (real estate and
equipment) and administrative expenses. The rule of thumb is: the
higher these expenses, the weaker the bank. The great historian
Toynbee once said that great civilizations collapse immediately
after they bequeath to us the most impressive buildings. This is
doubly true with banks. If you see a bank fervently engaged in the
construction of palatial branches - stay away from it.
Banks are risk arbitrageurs. They live off the mismatch between
assets and liabilities. To the best of their ability, they try to
second guess the markets and reduce such a mismatch by assuming part
of the risks and by engaging in portfolio management. For this they
charge fees and commissions, interest and profits - which constitute
their sources of income.
If any expertise is imputed to the banking system, it is risk
management. Banks are supposed to adequately assess, control and
minimize credit risks. They are required to implement credit rating
mechanisms (credit analysis and value at risk - VAR - models),
efficient and exclusive information-gathering systems, and to put in
place the right lending policies and procedures.
Just in case they misread the market risks and these turned into
credit risks (which happens only too often), banks are supposed to
put aside amounts of money which could realistically offset loans
gone sour or future non-performing assets. These are the loan loss
reserves and provisions. Loans are supposed to be constantly
monitored, reclassified and charges made against them as applicable.
If you see a bank with zero reclassifications, charge offs and
recoveries - either the bank is lying through its teeth, or it is
not taking the business of banking too seriously, or its management
is no less than divine in its prescience. What is important to look
at is the rate of provision for loan losses as a percentage of the
loans outstanding. Then it should be compared to the percentage of
non-performing loans out of the loans outstanding. If the two
figures are out of kilter, either someone is pulling your leg - or
the management is incompetent or lying to you. The first thing new
owners of a bank do is, usually, improve the placed asset quality (a
polite way of saying that they get rid of bad, non-performing loans,
whether declared as such or not). They do this by classifying the
loans. Most central banks in the world have in place regulations for
loan classification and if acted upon, these yield rather more
reliable results than any management's "appraisal", no matter how
In some countries the Central Bank (or the Supervision of the Banks)
forces banks to set aside provisions against loans at the highest
risk categories, even if they are performing. This, by far, should
be the preferable method.
Of the two sides of the balance sheet, the assets side is the more
critical. Within it, the interest earning assets deserve the
greatest attention. What percentage of the loans is commercial and
what percentage given to individuals? How many borrowers are there
(risk diversification is inversely proportional to exposure to
single or large borrowers)? How many of the transactions are
with "related parties"? How much is in local currency and how much
in foreign currencies (and in which)? A large exposure to foreign
currency lending is not necessarily healthy. A sharp, unexpected
devaluation could move a lot of the borrowers into non-performance
and default and, thus, adversely affect the quality of the asset
base. In which financial vehicles and instruments is the bank
invested? How risky are they? And so on.
No less important is the maturity structure of the assets. It is an
integral part of the liquidity (risk) management of the bank. The
crucial question is: what are the cash flows projected from the
maturity dates of the different assets and liabilities - and how
likely are they to materialize. A rough matching has to exist
between the various maturities of the assets and the liabilities.
The cash flows generated by the assets of the bank must be used to
finance the cash flows resulting from the banks' liabilities. A
distinction has to be made between stable and hot funds (the latter
in constant pursuit of higher yields). Liquidity indicators and
alerts have to be set in place and calculated a few times daily.
Gaps (especially in the short term category) between the bank's
assets and its liabilities are a very worrisome sign. But the bank's
macroeconomic environment is as important to the determination of
its financial health and of its creditworthiness as any ratio or
micro-analysis. The state of the financial markets sometimes has a
larger bearing on the bank's soundness than other factors. A fine
example is the effect that interest rates or a devaluation have on a
bank's profitability and capitalization. The implied (not to mention
the explicit) support of the authorities, of other banks and of
investors (domestic as well as international) sets the psychological
background to any future developments. This is only too logical. In
an unstable financial environment, knock-on effects are more likely.
Banks deposit money with other banks on a security basis. Still, the
value of securities and collaterals is as good as their liquidity
and as the market itself. The very ability to do business (for
instance, in the syndicated loan market) is influenced by the larger
picture. Falling equity markets herald trading losses and loss of
income from trading operations and so on.
Perhaps the single most important factor is the general level of
interest rates in the economy. It determines the present value of
foreign exchange and local currency denominated government debt. It
influences the balance between realized and unrealized losses on
longer-term (commercial or other) paper. One of the most important
liquidity generation instruments is the repurchase agreement (repo).
Banks sell their portfolios of government debt with an obligation to
buy it back at a later date. If interest rates shoot up - the losses
on these repos can trigger margin calls (demands to immediately pay
the losses or else materialize them by buying the securities back).
Margin calls are a drain on liquidity. Thus, in an environment of
rising interest rates, repos could absorb liquidity from the banks,
deflate rather than inflate. The same principle applies to leverage
investment vehicles used by the bank to improve the returns of its
securities trading operations. High interest rates here can have an
even more painful outcome. As liquidity is crunched, the banks are
forced to materialize their trading losses. This is bound to put
added pressure on the prices of financial assets, trigger more
margin calls and squeeze liquidity further. It is a vicious circle
of a monstrous momentum once commenced.
But high interest rates, as we mentioned, also strain the asset side
of the balance sheet by applying pressure to borrowers. The same
goes for a devaluation. Liabilities connected to foreign exchange
grow with a devaluation with no (immediate) corresponding increase
in local prices to compensate the borrower. Market risk is thus
rapidly transformed to credit risk. Borrowers default on their
obligations. Loan loss provisions need to be increased, eating into
the bank's liquidity (and profitability) even further. Banks are
then tempted to play with their reserve coverage levels in order to
increase their reported profits and this, in turn, raises a real
concern regarding the adequacy of the levels of loan loss reserves.
Only an increase in the equity base can then assuage the (justified)
fears of the market but such an increase can come only through
foreign investment, in most cases. And foreign investment is usually
a last resort, pariah, solution (see Southeast Asia and the Czech
Republic for fresh examples in an endless supply of them. Japan and
China are, probably, next).
In the past, the thinking was that some of the risk could be
ameliorated by hedging in forward markets (=by selling it to willing
risk buyers). But a hedge is only as good as the counterparty that
provides it and in a market besieged by knock-on insolvencies, the
comfort is dubious. In most emerging markets, for instance, there
are no natural sellers of foreign exchange (companies prefer to
hoard the stuff). So forwards are considered to be a variety of
gambling with a default in case of substantial losses a very
plausible way out.
Banks depend on lending for their survival. The lending base, in
turn, depends on the quality of lending opportunities. In high-risk
markets, this depends on the possibility of connected lending and on
the quality of the collaterals offered by the borrowers. Whether the
borrowers have qualitative collaterals to offer is a direct outcome
of the liquidity of the market and on how they use the proceeds of
the lending. These two elements are intimately linked with the
banking system. Hence the penultimate vicious circle: where no
functioning and professional banking system exists - no good
borrowers will emerge.
AUTHOR BIO (must be included with the article)
Sam Vaknin ( samvak.tripod.com ) is the author of Malignant
Self Love - Narcissism Revisited and After the Rain - How the West
Lost the East. He served as a columnist for Central Europe Review,
PopMatters, Bellaonline, and eBookWeb, a United Press International
(UPI) Senior Business Correspondent, and the editor of mental health
and Central East Europe categories in The Open Directory and
Until recently, he served as the Economic Advisor to the Government
Visit Sam's Web site at samvak.tripod.com